More on derivatives, Wall Street, production homebuilders and the warning ... by gimleteye

In recent posts, I've used the term "derivative" too loosely. I've been writing about derivatives and their connection to the housing market boom and crash for so long (see archive, "housing crash") that I lapse into short-hand. That is a mistake. If this blog had an editor, it wouldn't have happened. (Please click, 'read more'.)

InvestorWords defines derivatives this way: "A financial instrument whose characteristics and value depend upon the characteristics and value of an underlier, typically a commodity, bond, equity or currency. Examples of derivatives include futures and options. Advanced investors sometimes purchase or sell derivatives to manage the risk associated with the underlying security, to protect against fluctuations in value, or to profit from periods of inactivity or decline. These techniques can be quite complicated and quite risky."

The PBS series NOVA recently explored the complicated issue of derivatives, the failure to regulate these risky financial products, and how President Clinton's senior economic policy makers and Fed Chief Alan Greenspan killed regulation that otherwise might have prevented the biggest economic downturn since the Great Depression. The program was orgiinally broadcast on local PBS affiliate, WLRN. Frontline focuses on credit default swaps; in effect, insurance against certain risk outcomes bought and sold between counterparties.

But there are many other kinds of derivatives and the housing boom could not have occurred without them. Websters describes derivatives this way: "a contract or security that derives its value from that of an underlying asset (as another security) or from the value of a rate (as of interest or currency exchange) or index of asset value (as a stock index)."

For instance: residential backed mortgage securities: "RMBS. A type of mortgage-backed security composed of a wide array of different non-commercial mortgage debts. It securitizes the mortgage payments of non-commercial real estate. Different residential mortgages with varying credit ratings are pooled together and sold in tranches to investors looking to diversify their portfolios or hedge against certain types of risks."

Suburban sprawl is comprised of platted subdivisions: the same-ness and visual poverty of sprawl-land is precisely due to the requirement of derivatives: to deliver predictable rates of interest and return based on demographics. The formulas had to be easily replicated and easily approved by ratings agencies.

The point about the Growth Machine and derivatives is that the housing boom fed into Wall Street's frenzy to create new derivatives from thin air. Yes, the boom was caused by a credit bubble: but the credit bubble would not have existed without the metastasizing of derivates. These securities related to mortgages were an endless supply seeking demand. The demand was fabricated by homebuilders and bankers, who came up with creative-- and politically directed--campaigns like "The Ownership Society" to paint the picture of a hundred thousand suburbs needed to fill every land speculators' dream.

Wetlands mitigation banking is a form of derivative trading. A natural resource, X acres of wetland, is turned into a commodity that can be combined or otherwise offset by another wetland in another location. It is crystal clear that in Florida, treating the environment as a "derivative" was collateral damage necessary in the Miracle Grow equations of sprawl in Miami-Dade and elsewhere.

Big production homebuilders, like Lennar, need huge scale to accommodate shareholders' profit expecation. Not only does open space need to be scraped to bedrock to be built up for housing pads; large regions need to be outfitted by the engineering cartel for roadways and electricity and water pipes to service the derivatives-based profit models.

The Big Dogs team up with local small builders, like the constituents of the Latin Builders Association, who do the heavy lifting on local politics of zoning changes; requiring amendments to development plans adopted by the county or city. This is where lobbyists and law firms like Greenberg Traurig come in: they are an essential gear in the machine, linking up small parochial politics with homebuilders, with policies advocated by the National Association of Realtors, the National Association of Homebuilders and so forth. The bankers play their role of course. The entire edifice was designed to rain down the biggest and largest windfall of fee-taking, profit making, and borrowing.

On the Frontline website, Nobel laureate economist Joseph Stieglitz accurately summarizes; "In retrospect, we can see that our financial markets misallocated capital, mismanaged risk, created risk, and did it all at high transaction costs. It's very clear that they were involved in trying to maximize transaction costs. That's their revenues; that's their profits. Some of the innovations in risk management had the potential of enabling firms to undertake more risk than they otherwise would have by shifting the risk off to others, and that would have facilitated the growth of the real sector of our economy."

The chapter still to be written, and critics of this blog are anxious to dismiss, involves a closer description of the concert between developers, politics, and Wall Street; how derivatives fed the Growth Machine that now manifests in so much destruction: neighborhoods littered with foreclosures and ghost town suburbs.

That's the legacy of the boom; yet the Growth Machine and its key actors are still in place, idling in neutral as the case may be. Waiting for the sheetrock to fly off the shelves and the glue guns to fire up, once again.


NOTE: Check out the Frontline episode if you are new to the issue of derivatives; it is a wide brush comb and picks up the big bad actors in financial products: credit default swaps. I've seen enough of Larry Summers for a lifetime, yet the key Obama economic advisors include the same cast of characters-- minus Robert Rubin-- who were responsible for throttling the efforts to regulate these derivatives. The episode ends with Greenspan's chilling admission to a Congressional committee that his entire career's espousal of free market libertarianism was a mistake. It also includes a grim prognosis along the lines that the continual pressure by Wall Street to stop the imposition of regulations could lead to even more severe financial crises in the future.